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The purpose of this chapter is to explain to physicians how economists think about physicians’ decision-making with regard to the treatment of patients. Economists’ mode of thinking has shaped health care policy and institutions and thus the environment in which physicians practice, not only in the United States but in many other countries as well. It may prove useful for physicians to understand some aspects of the economists’ way of thinking, even if it sometimes seems foreign or uncongenial.

Physicians see themselves as professionals and as healers, assisting their patients with their health care needs. When economists are patients, they probably see physicians the same way, but when they view doctors through the lens of economics as a discipline, they see physicians—and their patients as well—as economic agents. In other words, economists are interested in the degree to which physicians and patients respond to various incentives in deciding how to deploy the resources over which they exercise choice. Examples of issues that would concern an economist include how much time physicians devote to seeing a patient; which tests they order; what drugs, if any, they prescribe; whether they recommend a procedure; whether they refer a patient; and whether they admit a patient to the hospital. In addition, patients consider the cost when they make a decision about whether to seek care.

To say that economists view physicians and patients as economic agents is not to say that economists consider financial incentives the predominant factor in the decisions that either physicians or patients make about treatment; it is to say only that these incentives have some influence on these decisions. In fact, the role played by financial incentives in medical decision-making may often be dwarfed by the roles played by scientific knowledge, by professional norms and ethics, and by the influence of peers. However, economic policy greatly influences financial incentives, and economists tend to focus on this domain. Their interest stems from fundamental economic questions: What goods and services are produced and consumed? In particular, how much medical care is available, and how much of other goods and services? How is medical care produced? For example, what mix of specific services is used in treating a particular episode of illness? Who receives particular treatments?

Physicians in all societies live and function in economic markets, although those markets differ greatly both from the simple competitive markets depicted in introductory economics textbooks and from country to country, depending on national institutions. Many of the differences between actual medical markets and textbook competitive markets cause what economists term market failure, a condition in which some individuals can be made better off without making anyone else worse off.

This chapter explains two features of health care financing that cause market failure: selection and moral hazard. A common response to market failure in medical care is what economists refer to as administered prices, ...

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